How the Market Punished Knight Capital

If there's one thing we do know for sure about the outcome of the Knight Capital (NYS: KCG) debacle, it's that Knight itself got brutally punished for its trading-software mishap. As such, I was a little surprised when my fellow Fool Michael Lewis lamented that Knight didn't experience "a true loss."

Right off the top, Knight's debacle left it holding huge amounts of stock -- reportedly $7 billion at one point -- that it never intended to buy. In order to maintain the liquidity that it needed to continue facilitating trades -- that is, keep its business running -- Knight needed to sell that stock. Because it needed the liquidity in a hurry, rather than try to offload all of that stock on its own, it sold it all to Goldman Sachs, in a block trade at a discount. This left Knight with a gaping $440 million loss. That hurts. No, wait ... that really hurts.

Because Knight didn't have that kind of scratch laying around, let alone that plus extra cash to continue operating its business as normal, it had to raise money from the outside. As you might assume, because Knight was in a precarious position, potential investors had a ton of bargaining power. The deal that ended up being struck involved Jefferies (NYS: JEF) , Blackstone (NYS: BX) , Getco, Stephens, Stifel Financial (NYS: SF) , and TD Ameritrade (NAS: AMTD) buying $400 million of 2% convertible preferred stock with a conversion price of $1.50 per share.

That's a little heady, so let's unpack that last part. The new investors stepping in are getting:

A 2% dividend (there is no dividend on Knight common stock).

The option to convert their preferred shares to common at $1.50 per share.

Liquidation preference over common shareholders -- that is, if something further goes wrong, they get paid out before any of the previous shareholders.

With around 93 million shares of Knight stock previously outstanding, the 267 million new convertible preferred shares give the new owners the primary ownership stake. Or 73%, if you want to be exact.

In all, this is really a dreadful outcome for Knight shareholders -- a group that includes CEO Tom Joyce, whose stake was worth about $16 million prior to the disaster. As the stock stands today, it's down about 70% from its pre-crisis closing price. But even the current (as of this writing) price of $3.07 may face pressure as investors digest the cost of the new convertible preferred dividend and the dilution.

And that doesn't even touch on the incredible reputational damage that Knight has sustained and the further fallout that could come if it's sanctioned, fined, or otherwise punished by the SEC or the NYSE.

So when Lewis writes: "For once, a market player like Knight needs to experience what the retail investor and the gambler experience -- a true loss," I emphatically agree with the spirit of what he's saying. But I'd point out that we don't have to wait for a player like Knight to experience such a loss, because Knight itself experienced just that awful loss.